On the other hand, the system did not prevent Morningstar from underestimating the collateral damage from the subprime-mortgage meltdown. Although the analysts weren't terribly bullish on financial stocks before things started to fall apart a year or so ago, they, like many others, didn't anticipate the massive losses in banks' securities portfolios. They were also prematurely bullish last year on stocks of homebuilders and were overly optimistic about the outlook for retailers and restaurants.
Determining how Morningstar's calls stack up against those of other research outfits is difficult. Morningstar doesn't provide data to consultants who compile independent rankings of stock-research performance because, Dorsey says, those rankings are short-term-oriented and aimed at traders and other professional investors.
To his credit, Dorsey publishes a quarterly warts-and-all critique of his analysts' performance on Morningstar's Web site, including a running tally of how their picks have collectively performed against Standard & Poor's 500-stock index. Despite a disappointing 2007, an equally weighted portfolio of Morningstar's five-star-rated stocks, held until their ratings fell to one star, would have returned an annualized 15% over the past five years through March 31. That's an average of nearly four percentage points per year better than the return of the S&P 500. Those numbers were better, however, before last year, when the portfolio of Morningstar picks lost 5%, trailing the S&P 500 by ten points.
While the results are important, most individual investors are just looking for sound advice in language they can understand. By that standard, Morningstar's reports, with their clearly spelled-out investing theses and best- and worst-case scenarios for each stock, are succeeding. "I'm not a professional trader, so I look for resources I understand to help me with my homework," says subscriber Pamela Terracciano, a nonpracticing attorney in Briarcliff Manor, N.Y., who uses Morningstar research to help manage her retirement portfolio and her husband's. "If I read something in a report that poses a question about a company, I know it's a question I need to answer before investing."
Some 80% of premium Web-site subscribers say they sign up for the fund information, but about half of those who renew cite the stock research as a reason, says Catherine Odelbo, Morningstar's president of individual business. "A lot of people come for funds, but they stay for stocks."
And even though services for individual investors are a shrinking part of Morningstar's overall business (its fast-growing institutional business accounted for more than half of revenues and two-thirds of operating profits last year), individuals remain an important strategic audience. "We believe wide acceptance of the company by retail investors is what drives a large portion of its business," says Marvin Loh, an analyst for investment bank WR Hambrecht.
That's good news for ordinary investors, who have always been a low priority for high-profile Wall Street analysts. If Morningstar's stock-research operation continues to succeed, perhaps it will send a message to Wall Street about the way things ought to be done.
A sampling of morningstar's current calls
UnitedHealth (symbol UNH): The health insurer is a narrow-moat business, which is Morningstar's way of saying it has a moderate competitive advantage -- in this case because of its enormous size ($75 billion in annual revenue). But what really makes the stock a buy is its low price. At $33 in mid June, it traded at a 45% discount to analyst Matthew Coffina's $60 estimate of UnitedHealth's fair value.
Sanofi-Aventis (SNY): A robust pipeline of new, patented drugs earns this French pharmaceutical firm a wide-moat rating. The new drugs should offset losses from those that have lost patent protection, such as allergy treatment Allegra, says analyst Damien Conover. He pegs Sanofi's fair value at $50. It traded recently at $35.
Central North Airport Group (OMAB): Morningstar calls this U.S.-listed Mexican airport operator an undiscovered growth company with a wide moat thanks to its regional monopoly. Low-cost airlines are driving an increase in air traffic that should result in double-digit revenue growth over the next five years, says analyst Adam Fleck. At $20, Grupo Aeroportuario del Centro Norte, as it is known in Spanish, trades well below Fleck's $31 estimate of fair value.
Amazon.com (AMZN): The online retailer earns a wide-moat rating for its innovative business. But analyst Joseph Beaulieu says the stock's $81 price tag makes sense only if you believe that Amazon's profit margins can keep growing steadily in today's uncertain environment for consumer spending (he doesn't). Beaulieu's fair-value estimate for the shares is $45.
Bucyrus International (BUCY): This no-moat maker of mining equipment has been a big beneficiary of rising commodity prices. But analyst Joel Bloomer says mining firms -- Bucyrus's customers -- may be the more profitable play. At $75, the shares trade for more than twice Bloomer's $33 estimate of Bucyrus's fair value.
MEMC Electronic Materials (WFR): The semiconductor industry is cyclical, and chips are commodities. So, in Morningstar's view, MEMC (a member of the Kiplinger Green 25) has no moat around its business, despite its role as a chip supplier to solar-panel makers. Analyst Andy Ng expects new chip supplies to flood the market and drag down prices. His fair-value estimate is $20, less than one-third of MEMC's recent price of $65.